Using Finance to Increase your Returns
After recently attending local property networking events it still amazes me that investors think it’s a good idea to buy properties for cash. Firstly, the financial returns are less when a property is purchased for cash. Secondly, it means a large amount of cash is tied up for six months as no remortgaging can take place until a period of six months has elapsed. This means if a bargain property opportunity comes along within that six month period you will miss out, unless you have more cash to hand. So start as you mean to go on i.e. gear the property on purchase with a mortgage, ideally 75% to 80% loan to value mortgage.
Mr & Mrs Smith don’t believe in finance. They use their £100,000 accumulated savings to purchase one investment property for cash. They let the property for £600 per month, i.e. £7,200 per annum. Due to inflation, the rent increases and eventually, after 5 years of fluctuations in the property market, the house increases in value by say 40%.
Outcome – MR & MRS Smith property investment now = £140,000
Note: This example of without gearing could be said as the same as if it were a stock market investment.
Mr & Mrs Jones use their £100,000 accumulated savings as deposits to buy £500,000 (five) of properties, just like the one Mr and Mrs Smith purchased. On this basis they also receive five times as much rental income, i.e. £3,000 per month or £36,000 per annum. The other £400,000 is borrowed (80% Loan to Value) and they pay interest on this amount of 5.0%. This works out to be £20,000 per annum. Therefore, net of interest they receive £16,000 per annum.
They are already better off than Mr & Mrs Smith, but what happens in years to come? Well it is probably safe to say that Mr and Mrs Joneses rental income will rise with inflation as per Mr & Mrs Smith. However, Mr & Mrs Joneses mortgage costs remain the same. Therefore, the gap between both couples rental income will continue to widen as time goes by!
We then need to look at the year 5 positions, when the properties have increased in value by say 40%. Mr & Mrs Smith have made a capital gain of £40,000 and have £140,000 worth of investment property. On the other hand, Mr and Mrs Jones have made a capital gain of £200,000, five times as much as Mr & Mrs Smith’s cash property investment (or stock market investment).
Outcome – Mr & Mrs Joneses property investment now = £700,000
The same principle is true whether you buy investment properties of £50,000 or £200,000. The larger the property value, for instance 10 times more, the greater the potential capital gain (£500,000 per property), but the greater the potential loss if property values goes down.
Note: As the property value goes up the rental yield generally comes down, which can lead to negative cash flow, and a definite negative cash flow if interest rates go up significantly.
As explained above many investors purchase investment properties for cash to create both an instant income and a property portfolio. Alternatively the funding process known as “Gearing” can be implemented.
As stipulated the mortgage amount is paid by the rental income; the difference represents the investor’s profit. There is no limit to the size of the portfolio that can be produced by implementing this system!
Let’s now look at what happens when Mr & Mrs Jones refinance their five properties after 5 years by the use of further advance/ re-mortgaging. Remember after 5 years their portfolio is now worth £700,000 in this example. At 80% Loan to Value this will raise £160,000 as an ‘Equity Release’ i.e. £560,000 less original borrowings of £400,000.
Mr & Mrs Jones then use the £160,000 as deposits to buy £800,000 (eight) of £100,000 properties. On this basis they now receive thirteen times (5 + 8) as much rental income, i.e. £600 x 13 = £7,800 per month or £93,600 per annum. Their total borrowings now total £640,000 + £400,000 = £1,040,000 (80% Loan to Value) and they pay interest on this amount of 5.0%. This works out to be £52,000 per annum. Therefore, net of interest they receive £41,600 per annum.
Outcome – Mr & Mrs Jones property investment now = £800,000 + £700,000 = £1,500,000
To some investors this all now starts to look very worrying, all those 000’s at first glance can look a daunting prospect. However, you shouldn’t be afraid of debt, just be mindful of it. After all, nations and countries are built on debt; America has over 15 Trillion dollars of debt.
Debt only becomes worrying and a problem if there is no mechanism to service the debt. Fortunately property provides a good and dependable income stream that can adequately service the debt providing the properties are not over geared (over financed), and exhibit a reasonable ‘Gross Yield’ of 7% or above.
Moving another 5 years ahead; due to inflation, the rent increases and eventually, after 5 years of fluctuations in the property market, the house increases in value by say another 40%. Note: This is fair to assume as since the 1950’s property prices have doubled on average every 7 to 10 years.
Outcome – Mr & Mrs Smith investment now increases from £140,000 by £56,000 to £196,000.
For Mr & Mrs Smith this represents a £96,000 increase on their original investment of £100,000, which is great but as you will now find out it’s not even half as great as the Joneses.
Outcome – Mr & Mrs Joneses investment increases from £1,500,000 by £600,000 to £2,100,000.
For Mr & Mrs Jones this represents a £960,000 (£2,100,000 less borrowings of £1,040,000 and £100,000 investment) or 10 times/ 1,000% gains on the original investment of £100,000. This means the Joneses are now property millionaires. Not only that let’s now look at the rental income situation for both parties now that 10 years has elapsed.
Note: It’s reasonable to assume that with inflation the rental income would increase by 50%, just as a loaf of Bread costing £1 will be £1.50 in 10 years’ time.
Rental Income Outcome – Mr & Mrs Smith £600 + 50% = £900 per month/ £10,800 per annum
Rental Income Outcome – Mr & Mrs Jones £7,800 + 50% = £11,700 per month/ £140,400 per annum less mortgage/ borrowing interest of £52,000 = £88,400 per annum
From this simple illustration you can see the Joneses are now living on easy street and the Smiths will still have to count the pennies in their later years. Furthermore when one property is empty (Rental Void Periods) the Smiths lose 100% their rental income, whereas the Joneses only lose 8% of their rental income; safety in numbers.
Caveat Emptor Statement – “Note for ease of illustration property maintenance and management costs have been excluded; this is just meant to be an illustration of what ‘Gearing’ can do providing you gain further knowledge on property management and investment skills.”
“So do try to Keep Up with the Joneses”